If bank chiefs think they have run into a bit of turbulence lately, they had better take another hard look at the safety instructions. They have seen nothing yet. The go-go years of expansion and high returns have gone. From now on bankers will be battening down the hatches. Some of the problems are purely the result of the cyclical down-swing. This is a legacy both of bad lending to overextended telecom companies and ephemeral dotcom firms, and the market abuses that have left parts of the industry blemished.
Distinguishing between such cyclical developments and secular trends is always tricky but there is plenty of evidence that the banking industry is also facing problems of a distinctly fundamental kind. Revenue growth, which peaked in 2000, is likely to be a lot slower in the coming years than in the 1990s. That means an industry already suffering overcapacity is set to become even more fiercely competitive.
"The days of riding the wave are over," says John Leonard, a senior London bank analyst at Schroder Salomon Smith Barney. Many senior bankers share this view, if not always publicly.
Models under scrutiny
The head of a leading global bank in London says: "Every banking model is now under the microscope. At times like this, when everyone is a little confused by what is happening in the financial markets, you have to go back to basics." Certainly, most bank strategies are receiving close critical attention from investors and analysts, whether it is bancassurance or universal banking, product-led retail banking or global wholesale banking.
As Dr Chris Gentle, a financial services specialist at consultants Deloitte & Touche, says: "There are big questions about banking, partly because of market conditions and partly as a result of pressures in the industry. Right now, everything is up for grabs."
"Obsolete," is Mr Leonard's verdict on the classic European universal model, offering everything to everyone at home and dabbling in the rest of Europe. No less starkly, Phil Middleton, head of European bank strategy at accountants Ernst & Young in London, says: "The bancassurance model is shot to hell. So is the universal banking model." There are too many banks. And increasing regulatory and consumer pressures may make it difficult, if not impossible for second and third-tier players to survive. "In the past, the less competitive banks have been able to shelter behind very high industry margins. But now, margins are much more depressed and core products are tending to be commoditised," says Mr Middleton.
Indeed, on some measures, there are a lot of Continental European banks that are not profitable, according to David Llewellyn, professor of money and banking at Loughborough University in the UK. While the banks have a positive rate of return on capital, this does not cover the cost of capital. They have what he calls a "negative economic value added" (EVA: rate of return on capital, minus cost of capital).
Even bank models hitherto lauded for their ability to deliver high earnings consistently, such as Citibank or Lloyds TSB, are not excluded from this reappraisal. Investors are asking if Citibank, the ultimate global financial conglomerate, has become an unwieldy bunch of businesses that is less valuable than the sum of its parts. Meanwhile, Lloyds may be a UK retail powerhouse, say analysts, but may soon become constrained if it cannot escape its domestic confines.
There are many other banks whose problems look more acute, notably in Germany (Commerzbank and Dresdner Bank, for instance) and Japan. Many banks will be forced to close down parts of their business or sell them off, particularly in the investment banking field. Few observers rule out the disappearance of some European banks altogether, probably in Germany. "There are many banks that do not do anything particularly well. And, being third best at everything is a recipe for disaster. The question the banks face is: are we going to be one of the survivors or one of the victims?" says Mr Middleton.
The search for direction
But if all last year's models are looking fragile, if not receiving the last rites, where do the banks go from here? Where is the new strategy that will help banks to survive the tougher years ahead? As the banks grope around for that magic strategy, the only sure thing is that nobody is confident that they have found it yet.
There is no shortage of proposed strategies from consultants and the banks, variously described as "a return to core competences" or "focusing on what you do best" or "differentiating yourself from the competition". Mostly, these strategies assume that consolidation in many countries is going to tail off sharply (with one or two notable exceptions, such as Germany), either because of disillusion with the effectiveness of mergers and takeovers or because of regulators' anti-trust concerns. Banks are more likely to shed unwanted businesses.
Multi-tasking reversal
In the 1990s, the majority of major banks wanted to do everything - investment banking, private banking, asset management, electronic banking, cross-selling of insurance and investment products. They were on a convergent course to be full-service financial firms. This is about to go into reverse. The future trend is more likely to be towards unbundling, outsourcing, and for joint ventures and partnerships to run non-core businesses. "Differentiated and divergent" is how Mr Leonard summarises tomorrow's banking sector.
Being a full-service bank may have seemed attractive during the good years. But it has left banks with a lot of high costs at a time when they are scratching for growth, and investors are demanding that they come up with new ways of boosting profits.
Technological developments are greatly increasing the possibilities for unbundling banks, allowing them to choose between, say, being product manufacturers - designing mortgages, small business loans and suchlike - or being distributors that specialise in customer relationships. What banks have to ask themselves is "what they want to be famous for. What is the model that will differentiate them from others and how are they going to execute it?" says Mr Gentle.
The challenge affects most banks. Michel Driessen, a partner in the financial services practice at consultancy firm Accenture in London, sees the world of banking dividing into three categories: global players; regional and major domestic players; and product or service specialists.
It is the banks in the middle group, representing about 85% of the total, that face the big growth challenge, he argues. They have to choose between three approaches, which he calls "product innovation", "customer intimacy" and "least cost provider". These are the three basic dimensions. "If you adopt one of these and ask: what does this mean for my strategy, what does it mean for my operating model, processes, organisation, infrastructure and culture, you will get a very different picture than for the other two dimensions," he says.
Whatever course they take, banks are running out of time if current revenue predictions are correct. According to analysts at Schroder Salomon Smith Barney, the banks' revenue growth in Europe's largest countries is set to halve from an average of about 8% a year in the 1980s and 1990s, to about 4% during the early years of the current decade. This reflects increased competition, lower nominal interest rates, higher product penetration, sluggish nominal growth of GDP and slower expansion in the capital markets.
A lot of bank revenue is tied to the growth of economic activity, reckons Mr Leonard. "You can offset the slower revenue growth for a while, if you can cut costs, but that gets increasingly hard to do. You can also offset it for a time if you can buy new businesses, keep the extra revenue and take out the costs," he says.
But this, too, has limitations. "The synergies of cross-border M&A is either side of zero, in the case of branch banking," he says. "This is partly because the technological and market requirements in each European country are different; partly because buyers tend to pay a high premiums for the assets; and partly because implementation is frequently difficult." Even in wholesale banking the cost savings from taking over firms is only 5% to 10%, he calculates.
It is no big surprise, however, that many bank chiefs view such revenue predictions as excessively gloomy. Matt Barrett, group chief executive of Barclays Bank, insists that financial services is still a growth industry. Mr Barrett, who took over at Barclays three years ago after departing the chairmanship of the Bank of Montreal, says: "I have never found any correlation between GDP growth and the expansion of bank revenue."
As people around the world become more affluent, private pension provision grows and previously illiquid assets become liquefied, "there will be more demand, not less, for financial services", he says.
Even so, "focus and selectivity will be the theme" of coming years, says Mr Barrett, and Barclays would be open to more strategic alliances of the kind it concluded two years ago with Legal & General, to distribute the insurance firm's savings and investment products. "We will continue to look at financial services and products that Barclays does [not itself provide] and that we could distribute for other quality providers," he says. And, conversely, it could provide Barclays' products, notably credit cards, to other financial firms that could white-label them as their own, he says. Under such deals (discussed but not yet agreed), Barclays would operate the cards but the other party would put its own brand name on them.
This approach may not be quite as neat and clear-cut as that suggested by the three-model constellation of Accenture's Mr Driessen, but it is heading in the same direction. The idea of banks or other financial firms distributing their products through partner institutions and sourcing products from yet other parties is emerging as one of the hottest new strategies around. In the words of one financial services consultant: "You don't need to own the cow to sell the milk."
Insourcing is not only being promoted by financial conglomerates such as Citibank, but is creating so-called monoline powerhouses that specialise almost exclusively in one or two business lines. So far, this has mostly been a US phenomenon. The monolines include banks such as State Street, Bank of New York, Northern Trust and Mellon Bank, which specialise in custody and other wholesale securities processing services and are among the biggest in the world in such businesses. Mellon Bank, in particular, has undertaken a dramatic transformation from a full-service bank into an asset and securities firm.
In the retail field, US credit card specialists MBNA and Bank One have proved to be highly successful monolines, expanding their market share (including breaking into the UK market and under-cutting the existing oligopoly) and white-labelling their card services.
Monolines, which have also emerged in other consumer fields, such as mortgages, are often among the most profitable banks on a risk-return basis.
Pooling functions
The pooling of routine banking functions is another way for banks to rationalise some of their activities. One such collaboration, to set up what is effectively a utility, is the deal between Barclays Bank, Lloyds TSB and technology service firm Unisys. In August 2000, they agreed to set up Intelligent Processing Solutions Ltd (iPSL) to process cheques (HSBC subsequently became involved). iPSL, which clears cheques for other banks as well as for its owners, is now estimated to handle between 70% and 80% of all UK cheques. Its creation amounts to a demerger of a non-core business, allowing the owning banks to share technology costs, gain economies of scale and greatly reduce the head count.
In Germany, Deutsche Bank, Dresdner Bank and Commerzbank have merged their mortgage businesses into a new company called Eurohypo, with similar ambitions. These kind of collaborations are widely seen as the wave of the future. Finance industry advisers at Deloitte believe that these pooled businesses will displace much conventional M&A in the banking industry. Mr Gentle sees business mergers as one end of a spectrum of collaborations that include asset swaps, outsourcing, joint ventures and strategic alliances. "You will see a wide fragmentation of strategies, as banks try to exploit what they think they are good at and shed what they are bad at," he says.
In many cases, banks are deciding to dispose of businesses altogether. Deutsche Bank, for example, has decided to rid itself of custody (sold to State Street) and passive asset management. Several banks, including Commerzbank, are trying to unload the asset management businesses that they bought or expanded in the late 1990s. And Rothschilds has put its fund management operation up for sale.
M&A history is chequered
There may be broad consensus that divergence and unbundling is the way forward for the banking industry but there is less agreement about the prospect for further straight takeovers and mergers, either inside countries or across borders. The history of M&A in the finance industry is chequered at best. Studies suggest that between 50% and 75% of all acquisitions destroy wealth rather than create it. Even so, some consultants expect another wave of cross-border M&A before long. Management consultants McKinsey, for example, reckon a combination of pressures will lead to consolidation among the 15,000 institutions that make up Europe's fragmented finance industry. Pressures to boost profits and achieve economies of scale will drive cross-border M&A moves, together with often informal restrictions on further domestic consolidation in many European countries, arising from concerns about diminishing competition, they suggest.
Although the net present value of the synergies from cross-border mergers has rarely exceeded 5%, according to McKinsey, some senior bankers think that this will be boosted in future by technological advances. In the past, it was hard to integrate the product platforms of, say, a French bank and a UK bank. It was necessary to maintain two separate operations. "Before long, it will be possible to sell French mortgages and British mortgages off the same pan-European platform," says an optimistic banker at one major European financial firm. This will not lessen, and will probably increase, the trend away from universal banking. The result, according to McKinsey's finance industry experts, could be the emergence of pan-European firms focusing on one of four areas: product development, distribution, infrastructure and wholesale banking.
Before that happens, however, corporate and investment banking seem certain to experience a lot of bloodletting. In the search for growth, many banks in Europe decided to expand into investment banking. The returns looked more attractive during the 'bubble' period than just making loans to corporate customers. "Now they are saddled with high costs bases and losses stemming from the lower credit standards that were applied in the later 1990s. It is failing strategy," says Simon Harris, global head of the corporate and commercial practice at Oliver, Wyman & Co, a strategy consultancy specialising in financial services. In a recent study of corporate and investment banking, Oliver, Wyman & Co concluded that the erosion of returns in the industry would force second and third-tier players to exit the market.
This is unlikely to be enough, however. To maintain returns at pre-2001 levels, the company estimates that the amount of capacity in the market will have to be further reduced by the equivalent of two or three major players. Among the top-tier players, Credit Suisse is already thought to be contemplating selling its investment banking arm (others in the premier league include Citigroup, JP Morgan, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS Warburg).
Those in the second tier that are widely seen as unlikely to survive in investment banking are ABN Amro, Dresdner Kleinwort Wasserstein, Commerzbank and perhaps even Société Générale and BNP Paribas. One suggestion is that two or three firms might combine their investment banking operations in a business merger or consortium.
"The clear lesson is that you cannot dabble in investment banking. You are either fully in or fully out," says one financial services consultant. It is a view that still profoundly divides bank chiefs. A top executive at a global bank in London, says the "integrated wholesale firms with a broad capability" will be successful in the difficult years ahead. Most importantly, in each activity that "you engage in, you have to be best in class or your business model is wrong". Barclay's Mr Barrett strongly disagrees that only a firm with all elements of investment banking can be successful. Since jettisoning its equity business, Barclays Capital has managed to win respect for a purely debt-focused model. Its increasing market share in the expanding credit markets shows that this model can work, he says.
"Let a thousand flowers bloom," says one industry adviser. "There is no single right model. There will be space for banks of all shapes and sizes. But there is not going to be any room for 'me too'. In future, being successful is also going to mean being good," he says.
